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Top of the reform

Despite the recent correction over the last few months, we anticipate this trend continuing, thanks primarily to structural reforms which are boosting earnings growth, historically low valuations and a pick-up in economic growth.

To improve competitiveness and boost profitability, many European companies have been restructuring their operations over the past few years and have examined ways to grow more profitably. Margin growth has improved as businesses become more efficient in their use of labour and capital. This corporate reform lies behind the region’s recent outperformance. Over the three years to July, the MSCI Europe index rose by 63.1 per cent compared with the MSCI World’s rise of 37.4 per cent and a more modest gain of 17.2 per cent for the MSCI US index.

As well as benefiting from restructuring, more recently, the region’s companies have been profiting from strong export growth and a recovery in domestic demand. With these trends expected to continue over the long term, firms should see further profit gains, which in turn will help boost share prices in Europe.

As well as prospering companies, equities are likely to be supported by an ongoing recovery in the European economy. After years of sluggish growth, Europe’s economies are finally showing signs of life, supported by both domestic demand, as unemployment falls and export growth.

Economic data is strengthening, with economic leading indicators all showing signs of strength recently. In particular, the German Ifo index of business confidence is at a 15-year high and the Italian business confidence survey at a five-year high.

Indeed, in the second quarter of 2006, Germany grew at an annualised rate of 3.6 per cent while the French economy expanded at a pace of 4.0 per cent (annualised) – both growth rates surprised on the upside.

Given the surprisingly rapid rates of growth in two of Europe’s biggest econ-omies, the eurozone economy could grow by over 2.5 per cent in real terms for this year as a whole, above the current consensus forecast of around 2.2 per cent.

Meanwhile, we expect the UK economy to grow by about 2.4 per cent in 2006. With economic data expected to stay healthy and Europe’s economies continuing to recover, share prices should be well supported.

Behind the reduced cost base and increasing margins mentioned above lies economic and regulatory reform. This story will persist throughout the highs and lows of economic and stock-market cycles. It includes the ongoing deregulation of the regional economy, driven by the EU, which is forcing companies to be more focused on their core activ-ities, or the slow but inevit-able economic reforms driven by national governments.

A key point to mention is that political Europe – which, judging by UK newspaper headlines, is always about to enter a state of paralysis – is not economic Europe. Economic Europe is notable for its world-leading companies, its currently very strong profits growth and M&A activity that is leading to cross-border mergers of a sort unimaginable 10 years ago.

Neither is economic Europe the same as stock-market Europe. The latter is supported by attractions of its own. Regional and global investors appreciate the strong fundamentals behind the euro currency, particularly relative to the US dollar. Meanwhile, stockmarket valuations are still attractive historically relative to local bond markets and local cash deposits.

Paul Shutes is client portfolio manager in the JP Morgan European equity group

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21st January 20193:05 pm

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